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1、In-process R&D To capitalize or expenseJ.Eng.Technol.Manage.23(2006)1832.elsevier4/locate/jengtecmanIn-processR&D:Tocapitalizeorexpense?ab,*ZhenDeng,BaruchLevaBaruchCollege,CityUniversityofNewYork,NewYork,NY,USAbSternSchoolofBusiness,NewYorkUniversity,44WestFourthStreet,Suite10-92,KaufmanMan
2、agementCenter,NewYork,NY10012,USA.Availableonline9March2006AbstractTheFASBrecentlyproposedthecapitalizationofacquiredin-processR&Dcoststoreplacethecurrentpracticeofexpensingthisitem.Thisproposalwilllikelybestronglyopposedbycorporateexecutives.Weexaminewhetherin-processR&Disanassetworthyofcap
3、italizationoranexpense,and,ifitisanasset,howreliableisitsestimate.Wefindasignificantassociationbetweenthevaluesofin-processR&Dandacquiringfirmscashflowsduringthe3yearssubsequenttoacquisition,therebysupportingtheFASBsproposaltorecognizein-processR&Dasanasset.Preliminarytestsarepositiveforther
4、eliability/objectivityofin-processR&Destimates.#2006ElsevierB.V.Allrightsreserved.JELclassification:G34;M41;03Keywords:R&D;Capitalization;Cashflows;Intangibles1.IntroductionThein-processresearchanddevelopment(IPRD)phenomenoncametothepublicsattentioninthemid-1990s,whenasubstantialnumberoflead
5、ingcompanies,particularlyinthehightechandscience-basedsectors,announcedcorporateacquisitionsinwhichincompleteR&Dprojectsconstitutedthemajorassetacquired.Whatraisedeyebrowsandtriggeredthemediasattentionwasthefactthat,followinganarcaneaccountingrule,theacquiringfirmsimmediatelyexpensedthejust-reco
6、gnizedvalueofIPRD,therebywritingoffmostofthevalueoftheacquiredentity.IBMsacquisitionofLotusDevelopmentCorpinJuly1995wasamongthefirstlargecasesinwhichIPRDplayedaprominentrole.ThetotalpricepaidforLotuswas$3.2billion.Followingthepurchaseaccountingmethod,IBMestimatedthefairvalueofLotustangiblenetassets*
7、Correspondingauthor.Tel.:+12129980028;fax:+12129954001.E-mailaddress:blevstern.nyu.edu(B.Lev).0923-4748/$seefrontmatter#2006ElsevierB.V.Allrightsreserved.doi:10.1016/j.jengtecman.2006.02.003Z.Deng,B.Lev/J.Eng.Technol.Manage.23(2006)183219(primarily,cash,accountsreceivable,landandbuildings)at$305mill
8、ion,andthefairvalueofidentifiableintangibleassets(trademarks,assembledworkforce,leaseholdimprovements)at$542million.Currentsoftwareproductswerevaluedat$290million,anddeferredtaxliabilitieswereestimatedat$305million.Andherecomesthecrownjewel:IBMestimatedthefairvalueofLotusIPRDnewproductsandservicesin
9、theprocessofresearchanddevelopmentat$1.84billion,constitutingalmost60%ofLotusacquisitionprice.Thismeantthattheacquisitionsgoodwillthedifferencebetweenacquisitionpriceandthetotalfairvalueofnetassetswas$564million.TheconsequencesoftheimmediateexpensingofIPRDandthemeansformanaging1(manipulating)earning
10、stheycreateattractedthemediaattention.AsindicatedbytheaboveexampleofLotusacquisition,thehigherthevaluationofIPRDaverysoftandsubjectivevaluetheloweristheresidualvalueofgoodwill,andinturnthelowerthehitstofutureearningsfrom2goodwillamortization.TheimmediateexpensingofIPRDalsoobviatedthefutureamortizati
11、onofthisassethaditbeencapitalized,furthercontributingtofuturereportedearnings.Finally,theimmediateexpensingofIPRDsubstantiallyreducedtheassetandequitybasesoftheacquiringcompany,therebyinflatingwidelyusedprofitabilitymeasures,suchasthereturnonassetsorequity.Nowonder,then,thatmanagersstronglysupportth
12、eexpensingofIPRD.Andnowonderthat,whentheFinancialAccountingStandardsBoard(FASB)inthelate1990sannounceditsintentiontoconsiderthecapitalizationofIPRD,itmetwithastrongoppositionofmanagers,3particularlythoseofhightechcompanies.Amajorunintended,yetexpected,consequenceoftheexpensingofIPRDwastheinflationof
13、IPRDvaluesbymanagersofacquiringcompanies;atemptingproposition,giventheconsiderableuncertaintyandsubjectivityofestimatingthevalueofincompleteR&Dprojects.Moreover,thisinflationarytemptationwasexacerbatedbytheabsenceofcomparablemarketpricestherearenomarketsinR&Dthatcouldserveasvaluebenchmarks.I
14、nthefirstsystematicstudyofIPRDcomprisingof375cases,DengandLev(1997)reportedthatthemeanandmedianratiosofIPRDtototalacquisitionpricewereboth72%,andthatthemeanratioofIPRDtotheequity(networth)oftheacquiringfirmswas41%.ThesehighratiosdemonstratethesignificanteffectsofIPRDexpensingonkeyfinancialvariableso
15、facquiringcompanies.ThehighvaluesofIPRDexpensedbyacquiringfirmsledtheSecuritiesandExchangeCommission(SEC)toclampdownonthesevaluations,forcingnumerouscompaniestorestatedownwardthevaluationofpreviouslyreported4IPRD,andtosignificantdecreasesinthesubsequentvaluationsofthisasset.Theburstingofthetechnolog
16、ystockpricebubblein2000andtheensuingrecessionsignificantlydecreasedthenumberofcorporateacquisitions,andwithittheeconomicimpactoftheIPRDphenomenon.Recently,however,alongwiththeeconomicandstockmarketrecovery,themergersandacquisitionactivitypickedup,bringingbacktotheforefrontthequestionableaccountingtr
17、eatmentofIPRD.ThisisthebackgroundforthecurrentreconsiderationoftheaccountingtreatmentofIPRDbytheFASB,whichmotivatesourstudy.Specifically,theFASBtheaccountingrule-makingbodyintheUnitedStatesnowproposesthatIPRDshallbecapitalizedandamortized,ortested1Forexample,inAugust1998,aWallStreetJournalarticlerep
18、ortedontheSECconcernsthatcompanieswereabusingtheIPRDcharges(MacDonald,1998).InMarch,1999,anotherWallStreetJournalarticlereportedtheimpactoftheSECcrackdownonthesizeofIPRDwrite-offs(MacDonald,1999).2Until2001,goodwillhadtobeamortizedoveraperiodofupto40years.SFASNo.142abolishedtheamortizationofgoodwill
19、andreplaceditwithanannualimpairmenttest.3TheFASBsubsequentlydecidednottopursuethereconsiderationoftheIPRDissue.4Inafollowupstudy,DengandLev(1999)reportthattheaveragesizeofin-processR&Dchargesasapercentageofpurchasepricedroppedto45%,from72%,formergersthatoccurredaftertheSECstartedtoscrutinizeIPRD
20、.20Z.Deng,B.Lev/J.Eng.Technol.Manage.23(2006)1832periodicallyforimpairment(seeSection2forelaboration).Thisproposedchangeofaccountingtreatmentraisesseveralimportantissues,foremostofwhicharethefollowingtwo:IsIPRDanassetworthyofcapitalization,andwhatisthetypicallife(amortizationperiod)ofIPRD?Below,weex
21、aminethesequestionsempirically,andweconcludethatIPRDcontributestofuturecashflowsandthusisindeedanasset,and,moreover,thatthelifeofthetypicalIPRDisatleast3years.Weprovideabriefreviewofrelatedresearchbeforeproceedingwithouranalysis:DengandLev(1997)documentedasignificantpositiveassociationbetweenexpense
22、dIPRDvaluesandquarterlyexcess(market-adjusted)stockreturnsinthequarterofacquisition,aswellaswithmarket-to-bookratiosattheendofthequarter,implyingthatinvestorsconsiderIPRDasavalue-enhancingasset,ratherthananexpense.Analternative,cynicalexplanationtothesefindingscannotberuledout:investorspositiverespo
23、nsetoIPRDisduetothelatterspotentialforinflatingfuturereportedearnings.WeovercomethisreasoninginthecurrentstudybyrelatingIPRDtosubsequentcashflows.Inanexperimentalsetting,Hopkinsetal.(2000)examinedwhetherdifferentmethodsofaccountingforbusinessacquisitionsaffectanalystsstockpriceestimates.Responsesfro
24、m113buy-sideanalystsandportfoliomanagersshowthattheyassignahighervaluetoacquiringfirmscommonstockwhentheacquisitionpremiumisimmediatelyexpensedasIPRDratherthancapitalizedasgoodwillandsubsequentlyamortized.DowdellandPress(2001)examinedtheimpactoftheSECsscrutinyofIPRDwrite-offsinthefinancialreportsofa
25、sampleoffirmsinthesoftwareandcomputerservicesindustryduring19961998.TheyfoundthatinspectionbytheSECsignificantlyreducedthesizeofIPRDwrite-offsfollowingtheSECactionandthatthisalsoledtomaterialdownwardrevisionsofpreviouslyreportedIPRDwrite-offs.Theauthorsalsodocumentedthatfirmswithhighprofitexpectatio
26、nsbyinvestors(measuredbyprice-to-earningsorprice-to-bookratios)wroteoffmoreIPRDthandidlow-expectationsfirms,whichtheyinterpretedasinconsistentwiththeincome-smoothingandbig-bathhypothesesofearningsmanagement.TheyalsoindicatedthatIPRDrestatementannouncementswerenegativelyassociatedwithabnormalstockret
27、urns(i.e.,investorsreactednegativelytoIPRDrestatements).Clemetal.(2004)documentedthemarketreactionstoaseriesofregulatoryeventsrelatedtoIPRDduring19981999.Theynotedthatthesamplefirmsstockpricesreactednegatively,onaverage,toannouncementsofSECscrutinyofIPRDcharges.Theyalsofoundapositivepricereactiontot
28、heFASBsdecisioninthelate1990sthatitwoulddeferitsplantorequirethecapitalizationofIPRD(seefootnote3).TheauthorsinterpretedthesefindingsasevidencethatinvestorsviewedthepotentialforincreasedregulationofIPRDchargesasdetrimentaltothevalueofR&Dintensivefirms.Theorderofourdiscussionisasfollows:Section2e
29、laboratesonthedifferencebetweenexpensingandcapitalizingR&D.Section3presentstheproposedaccountingchangeconcerningIPRD.Section4discussestheempiricaltestsandfindings,whileSection5reportsonapreliminaryreliabilitytest.Section6concludesthepaper.2.R&DexpensingversuscapitalizationAccountingrulesinth
30、eUnitedStates(generallyacceptedaccountingprinciplesGAAP)requirepubliccompaniestoexpenseallinternalR&Doutlays.ExpensingmeansthatquarterlyandannualR&Dexpendituresaresubtractedfromrevenues(sales)intheprocessofcalculatingnetincome(earnings).Themajorcharacteristicofanexpensethatdistinguishesitfro
31、manassetZ.Deng,B.Lev/J.Eng.Technol.Manage.23(2006)183221(capital)isthatitisnotexpectedtogeneratefuturebenefits.Thus,forexample,wagesandsalariesareexpensesbecausetheyarepaidforpastemployeeperformance,andrentispaidforpastplantoccupancy.ThisassetexpensedistinctionclarifiesthemajorcontroversyconcerningR
32、&Dexpensing:ThereisnodoubtthatR&Dactivitiesareexpectedtogeneratefuturebenefits,suchasfromsalesofdrugsorsoftwareproducts.Indeed,extensiveempiricalevidencedocumentssignificantstatisticalassociationsbetweencurrentandpastR&Dexpendituresbycompanies,andfuturegrowthinsales,earnings,andstockpric
33、es(seeLev,2001,Chapter3).WhythenexpenseR&D?Accountingrulemakersclaimthatwhile,onaverage,R&Disassociatedwithfuturebenefits,individualR&Dprojectsdevelopedbyspecificcompaniesarehighlyuncertain.Manyprojectsarediscontinuedorfailtoprovidereasonablereturnondevelopmentcosts.Accountingconservatis
34、m,itisclaimed,callsfortheexpensingofsuchuncertainR&D.ThealternativetoR&Dexpensingiscapitalizationthatis,therecognitionthatR&Dexpendituresconstituteanassetthatisexpectedtoprovidefuturebenefits,likeplant,machinery,orinventories.TheimpactofR&Dcapitalizationonreportedfinancialdataistwo-f
35、old.TheaccumulatedR&Dexpendituresappearonthebalancesheetamongthefirmsassets,ratherthanasexpenses,andthequarterlyorannualamortizationoftheR&Dcapital,whichreflectsthedecreaseovertimeintheassetsbenefits,isconsideredanexpenseandissubtractedfromrevenuesinthedeterminationofnetincome.Thus,undercapi
36、talization,amortizationreplacestheR&Dactualexpenditure,whichiscurrentlybeingfullyexpensed.Note,thatsuchcapitalizationofR&DisnotpermittedunderU.S.accountingrules.Theproposedchangethesubjectofthisstudypertainsonlytoacquiredin-processR&D,namelytheR&Dincludedinmergersandacquisitions,andn
37、ottointernalR&D.Somuchforaccountingrules.Butwhoisright?AccountingrulemakerswhoclaimthatR&Distoouncertaintodeservethecovetedstatusofanasset(capital),orthechallengers(e.g.,LevandZarowin,1999)whoclaimthatwhileindividualR&Dprojectsmaybeuncertainmostpubliccompaniesengageinthedevelopmentofport
38、folios(bundles)ofprojects(e.g.,drugsorsoftwareprogramsunderdevelopment)thatexhibitacombinedlevelofuncertaintythatisrelativelylow?SuchalevelofR&Duncertainty,claimthechallengers,isnotsignificantlyhigherthantheuncertaintyofothercorporateinvestments,suchasrealestate,stocks,orbonds,whicharerecognized
39、byaccountantsasassets.Ultimately,theR&Dexpensingversuscapitalizationcontroversyshouldbesettledonempiricalgrounds.Indeed,variousstudieswereaimedatresolvingthisissue.Herearetwoexamples.TheonlyexceptiontotheR&DexpensingruleintheU.S.issoftwaredevelopmentcosts.TheFASBruledin1985thattheR&D(dev
40、elopmentcosts)ofsoftwareprojectsthatsuccessfullypassedtechnologicalfeasibilitytests,suchasabetasite,shouldbecapitalizedandamortized.ThisallowedAboodyandLev(1998)toexaminewhethertheextentofsoftwaredevelopmentcoststhatwerecapitalizedandreportedonthebalancesheetsofsoftwarecompaniesasassetsare:(1)recogn
41、izedbyinvestorsassuch(i.e.,reflectedasassetsinstockprices),and(2)associatedstatisticallywiththefutureearningsofthecompaniesasexpectedfromassets.Theempiricalanswerstothesetwoquestionswereaffirmative.Thecapitalizedsoftwaredevelopmentcostswereindeedassets.Thesecondexampleofanempiricalstudyonthemeritsof
42、R&DcapitalizationdealswithregularR&D.LevandSougiannis(1996)usedreportedfinancialdataofpubliccompaniestodeterminethevaluesoffirmsR&Dcapitalanditsamortizationrate(thatis,toundotherequiredexpensingofR&D).ThiswasstatisticallyperformedbyrelatingafirmsearninginagivenyeartoitsR&Dexpendi
43、turesinthesameandprior10years.TheannualamortizationratesofR&Dwerederivedfromthepatternofstatisticalassociationbetweenearnings(thebenefits)andthe22Z.Deng,B.Lev/J.Eng.Technol.Manage.23(2006)1832laggedvaluesofR&Dexpenditures(thecosts).DerivingR&DcapitalandamortizationratesenabledLevandSougi
44、annistostatisticallydeterminewhetherinvestorsconsiderR&Danexpense(asaccountantsclaim)oranassetwhenpricingsecurities.Theevidence,oncemore,indicatedthat,onaverage,R&Disconsideredbyinvestorsanamortizableassetratherthanan5expense.Ontheotherhand,Kotharietal.(2002)providedevidencethatthecontributi
45、onofR&Dtothefuturevolatilityofearningsameasureofriskishigherthanthecontributionofcapitalexpenditures(physicalassets)toearningsvolatility.UnderwhatcircumstanceswouldR&Dcapitalizationandamortizationresultinsignificantlydifferentfinancialinformation(earnings,assetvalues)releasedtoinvestorsrelat
46、ivetoR&Dexpensing?ThedeterminingfactoristhegrowthrateofthefirmsR&Dexpenditures.WhenafirmsR&Ddoesnotgrowovertime,theannualR&Dexpenditures(insteadystate)willequaltheannualamortizationoftheR&Dcapital,hadR&Dbeencapitalizedandamortized,andthereforeearningswillbethesameunderexpensi
47、ngandcapitalization.However,whenthegrowthrateofR&Dispositive,typicaltomostcompaniesinagrowingeconomy,R&Dexpenditures(thecurrentaccountingexpense)arehigherthanR&Damortization,leadingtoearningsunderR&Dcapitalizationbeinghigherthanearningsunderexpensing.ThehighertheR&Dgrowthrate,the
48、higherthegapinearnings.Corporateassetsandequityvaluesreportedonthebalancesheetwillalwaysbehigherundercapitalizationthanunderexpensing,sinceevenwithazeroR&Dgrowthrate,R&Dcapitalizationwillresultinapositive(andunchanging)R&Dassetreportedonthebalancesheet.Finally,asensitiveissue:afrequently
49、voicedargumentagainstR&Dcapitalizationisthatitprovidesmanagerswithameanstomanipulatereportedearningsandassetvalues.SincetheamountofR&Dtobecapitalizedissubjective,managers,itisargued,canplaywiththecapitalizedamounttoreportearningsfiguresthatfittheirpurposes(e.g.,tosurpassearningsforecastsbyfinancialanalysts).Whencapitalizationisincreased,reportedearningswillgenerallyrise.Whilethereisundoubtedlysomevaliditytothemanipulation-via-capitalizationargument,twothingsshouldbekeptinmind.First,theevidencesupportingc